Lipitor Brand

Generic Lipitor

Like most first world countries, the United States uses the patent system to encourage research and development. If a pharmaceutical company can develop a new drug, they can maintain a government approved monopoly on the sale of that drug for up to 17 years. Monopolies drive higher prices, which helps the inventor, Pfizer in this case, recoup their research costs, and return a handsome income to their shareholders. Once the patent runs out, other manufacturers can apply to produce the drug. This increased competition then quickly drives down prices. So far, this is a classic example of market forces at work.

Pfizer has been planning for this day for a number of years, and with annual sales figures like those in 2010, this is vital to the company’s fortunes. The company has triggered a number of legal and regulatory efforts to delay the arrival of generic equivalents. For a compilation of news articles on Lipitor, see this page in The New York Times.

Two particular strategies twist prescription drug coverage in favor of the brand name. Many prescription drug plans have incentives to encourage patients and their physicians to use generic drugs. Often this is done with a lower co-payment on the part of the patient. The lower co-payment provides an incentive for the patient to accept a generic equivalent, and the insurance plan saves money by paying the lower, generic price. Pfizer (and other drug companies facing similar out-of-patent challenges) is trying to subvert this incentive. Here’s a hypothetical example.

These figures are illustrative – made up – but make the point.

Typical Brand vs. Generic Comparison for a Drug Plan

Brand:  Patient Copay: $30 – Total Cost of Drug: $200 – Insurance Pays: $170

Generic: Patient Copay: $10 – Total Cost of Drug: $50 – Insurance Pays: $40

Now Pharmaceutical Company Offers a Copay Discount
(Pfizer discounts its price of the brand drug to cover reduced copay)

Discount Brand: Patient Copay: $8 – Total Cost of Drug: $178 – Insurance Pays $170

With this discount arrangement the patient is happy, the drug store doesn’t lose any money, but the insurance company still pays the larger cost. This puts upward pressure on insurance premiums.

Another strategy – Pfizer offers a significant discount on the price of brand name Lipitor to pharmacy chains as long as they agree to not provide generic equivalents. The chains save money, and can pass some of that on to patients, but the insurance plans that pay for the drugs don’t enjoy any savings.

Is this legal?  The second, discounting strategy with pharmacies, smells a lot like restraint of trade/anti-trust concerns to me. The earlier example, offering a discount on copays, seems legal. Are either of these good social policies? Not a chance.

These creative approaches illustrate one of the problems that insurance introduces into a market. In healthcare, patients have enough discretion that they can alter their buying behavior, based on prices they face. Yet the patients don’t see or feel the full price of their purchase decision. In a regular market the patient balances the benefit of the purchase against the price, and makes a good decision on allocating resources. That good decision helps society. With insurance the patient sees only a small fraction of the total price, and may make a decision that is not socially optimal. This breakdown in market forces is one of the challenges our healthcare reform goals face. Ideally we would like patients to be full partners in the decisions made about their care. Insurance blunts that participation.

The phrase The Wisdom of Crowds is the title of a book by James Surowiecki, a staff writer for The New Yorker. In 2004 Surowiecki wrote that large groups of average individuals can predict outcomes with greater precision than smaller groups of experts. Intrade.com is a real-life, functioning demonstration of this claim.

First, a quick refresher. Anyone can start an account on the Intrade web site. You add a modest amount of money to your account using a credit card. Then you go to a specific event/market which predicts some outcome. The outcome is easy to verify, eventually. For example, there is a market for the outcome that President Obama is re-elected as president in 2012. Eventually that outcome will either be yes or no. As I write this on November 12, 2011 the prediction for this event is 52.1%. If I think it is likely that Obama will be re-elected I can buy a share in this event for $5.21. If I am right, and hold on to this share until the election I will receive $10.00 – a profit of $4.79.  If I am wrong, and hold on to the share I lose my $5.21. If others feel optimistic with me the “price” gets bid up.  If events alter my prediction, I can either buy more shares for the positive outcome or sell my shares.

Here is a graph of this particular prediction and how the Intrade investors have evaluated the President’s chances.

Intrade.com - Probability of President Obama being Re-Elected

You can click on the graph to see more information on this prediction. You can see that Intrade investors have gotten more pessimistic about the President’s chances over the last six months. An important thing to note is that anyone can play in this market. It is not a poll of political experts or those horrid talking heads we hear/see on broadcast media.

A Competitive Market

For my microeconomics students this is an example of a special form of a competitive market. There are many sellers (almost 2,000 to date) and an equal number of buyers. They all have approximately the same amount of information (no insider trading advantage in this case.) It is very easy to enter this market, and to leave it. There are few market imperfections – no monopoly, no obvious cartel.  If we assume, like Adam Smith did 240 years ago, that buyers and sellers will act in their own self-interest (making as much money as possible) then the market price will reach an equilibrium. That equilibrium price will change as new information arrives. For example, when Rick Perry forgets which federal agency he wants to close, some people may judge that Obama’s chances of re-election are slightly higher. They will bid the price up from $5.21 (52.1%) to something higher.

As an exercise consider Surowiecki’s claim that this large number of regular investors will more accurately predict the final outcome that a panel of experts.

In microeconomics we also look at the ways that labor and capital (equipment) can substitute for one another. As costs for one input rises, there is an incentive to purchase more of the other input. Decades ago the automotive manufacturers added more and more robotic assembly processes to their production, in part to deal with increasing labor costs. Catherine Rampell wrote an article and a blog post in The New York Times this week, on this topic.

In “Employers Spend on Equipment, Not Workers“, she points out,

Indeed, equipment and software prices have dipped 2.4 percent since the recovery began, thanks largely to foreign manufacturing. Labor costs, on the other hand, have risen 6.7 percent, according to the Labor Department. The rising compensation costs are driven in large part by costlier health care benefits, so those lucky workers who do have jobs do not exactly feel richer.

Labor theory suggests that as workers become more productive, the demand curve for labor shifts to the right, and should raise the equilibrium price (wages). This hasn’t been happening – in part because of high unemployment levels and an excess supply of labor. Rampell also argues that total compensation is rising – but that most of that increase is in benefit costs rather than wages.

In an Economix blog post she explores the health care benefit assertion further.

It may seem strange that the cost of labor is rising so fast. With such a weak economy, it doesn’t seem as if a lot of workers are getting raises. (Are you?)

And technically, employees are not getting much of a raise — at least not in cash. The higher cost of labor is primarily being driven by rising benefits costs and, in particular, rising health insurance costs.

[...]

[T]he benefits cost line is quite steep. Even more daunting to employers, it could get even steeper in the years ahead; health care costs are rising sharply, and their costs a year or two from now are very hard to predict.

Several take away points from this pair of articles. First – as capital equipment (particularly software-driven) improves and gets cheaper, we should expect it to substitute for labor. Second – health care costs drive so much of our economy, including the pace of unemployment changes.

One argument for preserving tax cuts, or lowering them generally is that they will increase incentives to work harder and longer. The Laffer Curve is based on this premise, saying that lower tax rates encourage more work and more investment, which results in more economic activity and growth, which in turn results in higher total tax revenues.

Harvard’s Gregory Mankiw started a gentle and funny conversation about this premise. In this op-ed piece in The New York Times Mankiw notes that when offered additional work opportunities, he often turns them down, because…

In effect, once the entire tax system is taken into account, my family’s marginal tax rate is about 90 percent. Is it any wonder that I turn down most of the money-making opportunities I am offered?

Mankiw’s article focuses on marginal tax rates – an important economic consideration. Rather than looking at a family/worker’s average tax rate, he argues that incremental increases in income are faced with higher tax rates. He goes on to say that these high marginal tax rates discourage him from accepting additional, incremental work – to the detriment of the economy.

This is the essence of what has been called supply side economics – freeing up the production/supply side of the economy will result in economic growth. While there is some strong theory behind these claims, the actual results have been hard to prove.

Stephen Colbert lampooned Mankiw in this piece.

And then a comedy troupe at Mankiw’s Harvard University added their punch.

OK, econ students, read this article and predict the impact of a rent control law on the mobile home market if it passes. Understanding that mobile home residents are lower income and probably hard hit by the recession, and certainly deserving of our sympathy, is this the best way to help them?

Extra credit – what will be the impact on other markets (forms) of lower cost housing?

Mark Thoma from the University of Oregon just up the road, speculates that voters attitudes about how much government should intervene might be related to the size of their town. From his post on his blog Economist’s Voice,

What I’m wondering is whether this can, at least in part, explain differences in attitudes toward regulation between more conservative rural areas and larger cities that are generally much more liberal. In a larger city, you are much more vulnerable to predatory type behavior, unfair treatment, much more likely to be dealing with strangers you have never seen before and will never see again.

With some reasonable qualifications, Thoma notes that tradespeople in small towns are known and that consumers have more information in order to make an informed decision. Thus, small town residents see less need for government intervention. It’s an interesting premise.

It never fails. No sooner does some calamity trigger an urgent need for basic resources than self-righteous voices are raised to denounce the amazingly efficient system that stimulates suppliers to speed those resources to the people who need them. That system is the free market’s price mechanism — the fluctuation of prices because of changes in supply and demand.

Thank you to Anya Quinn on Flickr for the use of this image.

We all reflexively abhor an opportunist, who raises prices on a critical item just when it is needed the most. Yet, pricing is what allows society and its members to make thoughtful judgements on the best use of scarce resources. Read through the article, and ponder a bit.

P.S. – My friend, Melanie, writes PrattleNog, and her blog just got a day’s worth of fame on the WordPress home page. She teaches and works with adult students at Marylhurst University and sometimes teaches a course on Social Media. I noticed that she has been scrupulous about crediting the source of her images, and properly chastened I vowed to emulate her. This particular image is made available for sharing under the Creative Commons licensing site/movement. I’m including the official attribution below, but if you are interested in the whole digital copyright brawl, follow the CC link for more information.

Slate published this article, “Sweet Surrender: Taxing soda to make you stop drinking it.” This is another example of using an excise tax to change consumer behavior. If one believes that there are negative externalities to the consumption of sugar-laden, artificially-flavored, carbonated water, then these taxes fall under the Pigovian Tax label.

From the April 9 edition of The New York Times, comes a report of a public-private solution to the management of commerical fishing stocks off the coast of New England. As with most commercial fisheries, the fish population is declining, due to over-fishing. The Federal Government, through NOAA and regional councils, sets limits on fish catches – hoping to keep fish stocks sustainable. Within those limits, however, fishing boat owners compete to find the fish. Now NOAA is instituting a private ownership system.

In an ownership, or “catch share,” system, individuals, companies, cooperatives, communities or other entities receive the right to take a set percentage of the annual catch of particular fish in particular areas. The system gives fishermen a powerful motive to fish sustainably, because the value of their share rises as fish stocks increase.

The economic concept here is that private ownership will increase the sense of responsibility on the part of group owners, and that they will make decisions to increase the long term value of their ownership investment.

The report mentions an estimate that a 10% rise in cigarette prices results in a 7% drop in smoking among youth and a 4% drop in smoking among adults.

There are a variety of studies on the price elasticity of demand for cigarettes, with varying estimates. The Surgeon General’s office issued a report summarizing the findings from a number of published studies. While the estimates differ some, the difference of elasticity between adults and youth smokers remains significant.

So, let’s review what price elasticity measures. The value of E is the ratio of the percent change in quantity demanded over the percent change in price. For a normal good, E should be negative – i.e. an increase in price yields a drop in quantity demanded, and a decrease in price yields an increase in quantity demanded. In either case one part of the ratio is negative, so the value of E is negative.

The figures reported by NBC (and many of the studies summarized by the Surgeon General’s office) show price elasticity for adults and children to be less than one. More accurately, the absolute value of E is less than 1.0. That means that quantity will change, percentage-wise, less than the change in price. OK – that makes sense. Smoking is understood to be addictive, and so we would expect that smokers might cut down on smoking as prices rise, but not by much.

What, then, is the explanation for youth smokers being “less inelastic”? Perhaps they are less addicted, since their experience with smoking is shorter. They also probably have less disposable income, and so even a modest price rise cuts into their budget more deeply. Are there other explanations?

By the way, the cigarette tax is an excise tax. Given the inelastic demand, we will expect only modest declines in smoking, but the government can expect to generate significant tax revenue.